Beware of Hidden Fund Costs

Frequent trades can also generate big tax bills, which further undercut performance. When a fund sells a security that has appreciated, it generates a capital gain that must be passed along to shareholders.

A recent study by Lipper Research indicates that over the past decade, the average stock fund gave up 1.6 percentage points in annual return to federal taxes on capital gains and dividend distributions, while the average bond fund gave up 2.4 percentage points in annual return. These figures don't even take into account state and local taxes.

Morningstar supplies information on its Web site about funds' potential exposure to capital gains, and this can give you a sense of their future distributions. Fund families also announce future distributions on their Web sites.

Investors may want to avoid purchasing any fund just before the end of the year, when they tend to make distributions. And if you consider holding funds that trade frequently, generating big tax bills, you should do so in retirement accounts so the tax bite will be deferred.

Holding large amounts of money in cash can also act as a drag on a fund's performance, although managers have to keep some cash on hand to meet redemptions from shareholders, and they generally scale up or down on cash positions when their view of the market changes.

Alan Seigerman, chief operating officer of ReFlow, a San Francisco company that helps mutual funds manage their cash flows, says the trades that fund managers make to put new money to work, or to liquidate holdings to meet redemptions, "are poor producing trades," since managers may not be not be able to time their purchases or sales optimally.